Going for Growth 2009 - the economic crisis facing OECD countries should not be allowed to slow down structural reforms

We are indeed in extraordinary times, and the information that keeps coming in suggests that the crisis is deepening by the day. In particular, the collapse of industrial production that was apparent as of the end of last year (page 6 in the handout) is continuing during the current first quarter of 2009. And even more disturbing, OECD measures of financial conditions suggest that the situation is likely to worsen before it improves. We will have more to say about the ongoing recession and subsequent recovery when publishing our Interim Assessment and Outlook for OECD economies on March 31.

Today’s report is designed to help OECD countries pursue reforms that will raise their long-term living standards. This year’s Going for Growth is special in that it comes at a time when OECD countries are faced with the most severe financial and economic crises in a lifetime. The still-unfolding global crisis and recession have inevitably raised questions about the extent to which markets can be trusted to deliver good outcomes and whether earlier reforms have contributed to make economies more vulnerable. The current crisis in financial markets has uncovered major problems with the functioning of financial markets and demonstrated the failures of past regulatory and supervisory structures to ensure market stability. It shows the destructive force of particular developments and imperfections in financial markets that have intensified risk taking and information deficiencies in financial institutions. These faults are starting to be recognised and countries are beginning to work individually and jointly to identify the best ways to reform regulation of financial markets. This key work aims to correct the particular market and regulatory imperfections that led to the current crisis, making financial intermediation and the real economy more resilient to future shocks.

However, it is important to emphasise that the debacle in financial markets does not call into question the beneficial effects of recommended reforms of product and labour markets in this report. A number of reforms throughout OECD countries in recent years have demonstrably shown their power to raise employment and productivity. Acting on the reform agenda set out in this report would significantly strengthen economic performance in the long term. In addition, more flexible product and labour markets are likely to improve country resilience in order to weather future downturns with less disruption to output and jobs.

The crisis, nonetheless, has implications for the choice of which structural policies to pursue in the near term. At a time when aggregate demand is well below productive capacity, it is apt to focus on those structural reforms that are most likely to raise demand in the short run as well as supply in the long run. Indeed, the structure of fiscal packages proposed or implemented in many OECD countries has also been shaped by concerns of their long-term impact on growth.

This report identifies broad fiscal/structural reforms that could yield a “double-dividend” at present:
Introducing infrastructure projects that can be brought on-stream quickly or improve the quality of existing facilities, particularly schools.

Boosting spending on training programmes to give workers skills that will be needed as the labour market recovers.

Cutting taxes on labour income, particularly for those with low wages. This will help boost consumption and improve long-term job prospects.

Reform anti-competitive regulations in product markets. Obstacles to businesses entering new markets should be reduced to stimulate the creation of new products and businesses, so boosting demand. Over the long-term stronger competition will help raise productivity and living standards.

Because crises can unmask weaknesses in existing policies, they are periods when important reforms are often initiated. But the report warns that when politicians are under pressure to act quickly, they risk implementing policies that are ultimately bad for growth. In the past, the erection of import barriers in the 1930s helped to transform a downturn into the Great Depression, and the responses to the crisis in the 1970s that were intended to reduce unemployment with early retirement schemes damaged European growth. Under no circumstances should mistakes from previous crises be repeated.

In addition, state aid and subsidies to help non-financial sectors and firms – for example, to the car industry, construction, iron, and steel – are both inefficient and unfair. These subsidies risk delaying necessary adjustments to new economic circumstances and creating costly dependence on public support. If such measures are taken, they should be phased out quickly.

This report also has special chapters on taxation, infrastructure investment, product market regulation, and the effect of population structure on employment and productivity. I will say a few words about these areas, which are relevant to the current crisis, and will be happy to elaborate in the question and answer.

The special chapter on taxation and growth concludes with a ranking across different taxes with respect to their impact on long-term growth (see handout, page 7, on large differences in tax structures across OECD economies). Corporate income taxes are the most harmful for growth, followed by labour income taxes and then indirect taxes, with property taxes the least harmful. Countries currently relying disproportionately on taxes levied on corporate and labour income could therefore raise GDP per capita by shifting their tax base towards goods and services as well as property. This is a promising strategy for the medium and long term, but it may have to be accompanied by supporting measures to counter any weakening of redistribution via the tax system.

However, it is less obvious that this “tax and growth” ranking can be exploited for short-term demand purposes in the current crisis. Lowering tax rates on corporate income is unlikely to have much impact on investment demand as corporate profits slump, and raising taxes on property would weaken already-depressed housing markets. As I have just noted, in the short term, cutting taxes on labour income, particularly for those with low wages, would help boost consumption and improve long-term job prospects. (As shown on p. 7, tax burdens on low-income workers are very high in many OECD countries, providing space for significant cuts).

The special chapter in this report on the long-term impact of infrastructure on GDP per capita comes at the right time, considering the focus of many recent fiscal packages on infrastructure spending to boost the economy. Though infrastructure investment has fallen in many OECD countries in recent years (see page 8), such investment may have positive spillover effects throughout the economy. Nonetheless, infrastructure investment has also been frequently wasted in the past, and to get the strongest growth effects from infrastructure investment, it is essential to carefully select projects on the basis of cost-benefit analysis and have in place regulatory structures that ensure competition where it is possible and prevent abuse of market power where competition is not feasible (see page 9 of handout).

Another chapter shows that most OECD countries have made significant progress in reducing regulatory constraints on competition in product markets over the past five years (see page 10). This bodes well for innovation and productivity in the longer term, and may prove helpful in dealing with the current crisis. Notwithstanding this progress, regulations still unduly constrain healthy competition in some sectors, notably in lower income OECD countries. Reforming regulations (especially entry barriers, see page 10) is a priority for several countries to enhance their productivity in the long run, with some beneficial effects on demand in the short run.

A final chapter shows that a significant proportion of the cross-country difference in employment rates and average productivity levels, and thus GDP per capita, is accounted for by differences in population structure, in particular educational attainment. It re-emphasises the importance of education, especially in the long run.

The report concludes that the economic crisis facing OECD countries should not be allowed to slow down structural reforms. Opportunities for reforms should be exploited to strengthen economic dynamism and living standards. Under no circumstances should mistakes from previous crises be repeated. In particular, attempts to cut unemployment by reducing labour supply would prove as damaging as in the past and leave our societies poorer. State subsidies to particular industries and firms should be kept to a minimum. Keeping external markets open and avoiding new protectionism is key to strengthening prosperity throughout the world.